introduction At the most basic level exchange rates are determined by demand and supply of one currency relative to the demand and supply of another However differences in relative demand and supply explain the determination of exchange rates they do it only in a superficial sense ID: 1027496
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1. Theories of exchange rate determination
2. introductionAt the most basic level, exchange rates are determined by demand and supply of one currency relative to the demand and supply of another.However differences in relative demand and supply explain the determination of exchange rates, they do it only in a superficial sense.
3. introduction
4. Prices and exchange rates
5. Law of one priceThe law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.For example: 1£=$2A jacket that retails for $80 in New York should sell for £40 in London.Consider what would happen if the jacket is selling for £30 in London (which should be then in this case according to the ER be selling at $60 in New York, but this does not happen)ARBITRAGE!!!
6. Purchasing power parity (PPP)-absoluteIf the law of one price were true for all goods and services, the PPP exchange rate could be found from any individual set of prices.By comparing the prices of identical products in different currencies, it would be possible to determine the real or PPP exchange rate that would exist if markets were efficient.
7. Ppp-example
8. Purchasing power parity (PPP)-relative
9. Purchasing power parity (PPP)-relativeThus, PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates.
10. Money supply and price inflation
11. Money supply and price inflation
12. Evaluation of PPP theoryEmpirically, Holds true in long-run but not a strong predictor of short term movements in ERBetter prediction for underdeveloped capital markets but less useful in predicting in case of advanced industrialised nationsAssumes away transportation costs and barriers to tradeThe demand is not always identical, differentiation in products is an important factor leading to price discriminationGovernments also intervene in foreign exchange marketsImpact of investor psychology and other factors in price determination weakens PPP
13. Interest rate parity (IRP) theory IRP theory is a theory that suggests a strong relationship between interest rates and the movement of currency values.It suggests that future exchange rates will be dependent upon the differences in interest rate in two countries.
14. Interest rate parity (IRP) theory
15. Interest rate parity (IRP) theory-example
16. Interest rate parity (IRP) theory-example
17. Interest rate parity (IRP) theory-example
18. Interest rate parity (IRP) theory
19. Interest rate parity (IRP) theory-implications
20. Interest rate parity (IRP) theory-implications
21. Interest rate parity (IRP) theory-implications
22. Fischer effect
23. Fischer effect
24. Fischer effect
25. Fischer effect
26. Fischer effect
27. Investor Psychology and bandwagon effect